Offer In Compromise And Reasonable Collection Potential

Command Central is working two Collections cases with the same revenue officer.

For the most part, I am staying out of it. There is a young(er) tax guy here, and we are exposing him to the ins-and-outs of IRS procedure. This is a subject not taught in school, and training today is much like it was when I went through: a mentor and mouth-to-ear. Friday morning we spent quite a bit of time trying to determine whether someone’s tax year was still “open,” as it would make a substantial difference in how we approach the situation.

COMMENT: This is the statute of limitations. The IRS has three years to assess your return and then ten years to collect. Hypothetically one could get to thirteen years, but that would require the IRS to run the three-year gamut before assessing and then the ten-year stretch to collect. I do not believe I have ever seen the IRS do that. No, of greater likelihood is that the taxpayer has done things to suspend the statute (called “tolling”), things such as requesting payment plans or submitting offers in compromise. Do this repetitively and you might be surprised at how long ten years can stretch. 

Personally, I suspect one of these two clients is dead in the water.

Why?

Let’s like at some inside baseball for an offer in compromise.

Collections looks at something called reasonable collection potential (RCP). As a rule of thumb, figure that the IRS is looking at a bigger number than you are. RCP has two components:

(1)  Net realizable equity in your assets

The classic example is a paid-off house.

To be fair, the IRS does spot you some room. It will use 80% (rather than 100%) of the house’s market value, for example, and then allow you to reduce that by any mortgage. Yes, the IRS is pushing you to refinance the house and take out the equity. It is not unavoidable, however. The push could be mitigated (if not stopped altogether) in special circumstances.

(2)  Future remaining income

This is a multiple of your monthly disposable income.

Monthly disposable income (MDI) is the net of

·      Monthly income less

·      Allowable living expenses (ALE)

Trust me, what you consider your ALE is almost certain to be significantly higher than what the IRS considers your ALE. There are tables, for example, of selected expense categories such as allowable vehicle ownership and operating costs. The IRS is not going to spot you $1,000/month to drive a luxury SUV when calculating your ALE. You may owe it, but they are not going to allow it. Yep, the math has to give, and when it gives, it is going to fall on you.

MDI is then multiplied by either 12 or 24, depending on which flavor offer in compromise you are requesting.

The vanilla flavor, for example, requires you to submit a 20% deposit with the offer request.

That is a problem if you are broke.

Then you have to pay the remaining 80% payments over five months.

 But – you say – that 80% includes twelve months of income. How am I to generate twelve months of income in five months?

I get it, but I did not write the rules.

Let’s look at a recent case. We will then have a quiz question.

Mr. D owed taxes for 2009 through 2011, 2013 through 2017, and payroll tax trust fund penalties for quarter 2, 2014 and quarters 3 and 4, 2015. These totaled a bit under $410 grand.

Shheeessshhh.

Mrs. D owed taxes for 2011 and 2013 through 2017.

OK. Those were joint income tax liabilities and would already have been included in Mr. D’s $410 grand.

They filed and owed with their 2018 return.

In March 2020 they requested a Collection Due Process Hearing.

They filed and owed with their 2019 return.

In July 2020 they offered $45,966 to settle their personal taxes for 2009 through 2011 and 2013 through 2019. Total personal tax was about $437 grand.

Now began the Collections dance.

Their offer was submitted to the specialized unit that works with offers. The unit wanted more information. The D’s had disclosed, for example, that they had retirement accounts.

The IRS asked: could you send us paperwork on the retirement accounts? 

The D’s send information for her IRA but not for his 401(k).

COMMENT: It almost never works to play this game.

The IRS calculated RCP based on their best available information.

Let’s look at just one facet: the house.

The D’s said the house was worth $376,600 on their original application. It had a mortgage of $310,877.

The IRS said that the house was worth $680,816.

COMMENT: Really? Did they think the IRS had never heard of Zillow or Movoto?

Following is the taxpayers’ comment:

On September 24, 2021, petitioners acknowledged that this value did not reflect the actual fair market value of the personal residence, stating that ‘we always start low as the initial starting point of the negotiation.’”         

COMMENT: Again, it almost never works to play this game.

Here is the math for NRE:

FMV	680,816
	80%
Adjusted	544,653
Mortgage	(310,877)
RCE	233,776

                                          

 

 

The D’s argued that the $680,816 value for the house was ridiculous.

They had it appraised at $560,000.

The IRS said: OK. Even so, here is the NRE:              

FMV	560,000
	80%
Adjusted	448,000
Mortgage	(310,877)
RCE	137,123

The IRS of course determined the D’s could pay significantly more than their proposed offer. I want to stop our discussion here and go to our quiz question:

I have given you enough information to know the IRS would turn down their offer of $45,966. How do you know?

Go back and review how RCP is calculated.

It is the sum of realized assets and some multiple of income.

The offer was less than RCP.

In fact, it was less than the asset component of RCP.

Could it happen? Of course, but it would take exceptional circumstances: think elderly taxpayers, maybe severe if not terminal illness, the residence being the only meaningful asset, etc.

That is not what we have here.

So the D’s tried a gambit:

Petitioners propose that this Court find as fact their allegations that the SO was ‘hostile, irate [and] yelling’ and ‘not qualified to be impartial and honest in this case.’”

That might work. Must prove it though.

Jawboning the SO when gathering information does not seem like such a brilliant idea now.

Here is the Court:

Since the record before us (which we are bound by) is silent as to any of the SO’s alleged acts of impropriety or bias, we find this argument by petitioners to be unsubstantiated.”

Offer denied.

Our case this time was Dietz v Commissioner, T.C. Memo 203-69.

A Penalty Against A Tax Preparer

 

Did you know that the IRS can assess penalties against a tax preparer as well as a taxpayer?

I am looking at an IRS Chief Counsel Memorandum recommending a preparer be penalized for a deduction on a client return.

You do not see that every day.

Let’s talk about it.

As is our way, we will streamline the issue so that it is something you might want to read and something I might want to write.

A taxpayer accrued expenses on its books for customer early payment discounts and estimated write-offs for disputed billing and shipping charges.

Sure, easy for a CPA to say.

Let’s clarify. The company sold stuff. It allowed discounts if a customer paid early. It also had routine billing disputes – for quantity, quality, price, damage and so on. As part of its general accounting, it estimated these charges and recorded them as expenses when the related sale was recorded.

Makes sense to me. Generally accepted accounting wants one to record all related expenses when the sale is recorded. This is called the “timing principle,” and the idea is to present net profit from a sales transaction as well as reasonably possible. What if all the expenses are not known at that precise moment - say, for example - the amount of product that will be returned because of damage in shipping? Generally accepted accounting will allow one to estimate that number, normally by statistical analysis of historical experience.

BTW you better do this if you expect to have your financial statements audited. Part of an audit is a review of your accounting method, and the “estimate that number” described above is considered a best-of-breed.

Generally accepted accounting might not work when you get to your tax return, however. Why? Well, generally accepted accounting is trying to get to the “best” number in an economic sense. Tax accounting is not trying to get to the “best” number; rather, it is trying to measure your ability to pay. Pay what? Taxes, of course.

Let’s go back to our taxpayer. They estimated a bunch of expenses when they recorded a sale. They included those numbers on their financial statements. They then wanted to deduct those same numbers on their tax return.

Problem:

The taxpayer utilized statistics to record the expenses for the two items. The courts held that statistics were not a valid method to record the amounts.”

Their CPA firm had to review the accounting method and decide whether it was acceptable for tax purposes.

There is even a Code section and Regulations:

           Reg § 1.461-1. General rules for taxable year of deduction

(a)(2) Taxpayer using an accrual method.

(i) In general. Under an accrual method of accounting, a liability (as defined in §1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. 

 

You see that last sentence and its reference to “economic performance?”

 

For generally accepted accounting, one must:

        

·      Establish the fact of the liability.

·      Measure the amount of the liability with reasonable accuracy.

 

Tax then adds one more requirement:

        

·      Economic performance on the liability must have occurred.

 

That third requirement is what slows down the tax deduction.

 

What is an example of economic performance?

 

Say that you record expenses for services related to the sale. Economic performance wants to see those services performed before allowing the deduction. What if you know - because it has happened millions of times before and can be calculated with near-arithmetic certainty – that the services will occur? Tax doesn’t care.  

 

But the auditors signed-off on the financial statements, you say. Doesn’t that mean that experts agreed that the accounting method was valid?      

A taxpayer’s conformity with its accrual method used for financial accounting purposes does not create a presumption that its tax accrual method clearly reflects income.”

And there you have a brief introduction to why a company’s financial statements and its tax return might show different numbers. Financial statement accounting and tax accounting serve different purposes, and those differences have real-world consequences.

 

In this situation, I side with the IRS. Work in a CPA firm for any meaningful period and you will see tax people repetitively “tweak” the audit people’s numbers. It happens so often it has a term: “M-1.” Schedule M-1 is a tax schedule that reconciles the profit per the financial statements to the profit per the tax return. The possible list of differences is near endless:

 

·      Entertainment

·      Depreciation

·      Allowance for uncollectible receivables

·      Accrued bonuses

·      Reserve for warranties

·      Deferred rent

·      Controlled foreign corporation income

·      Opportunity zone income

 

And on and on. Knowing these differences is part of being a tax pro.

 

The Chief Counsel wanted to know why the tax pros at this particular CPA firm did not know that this generally accepted accounting method would not work for purposes of the tax return.

 

To be fair, methinks, because it is complicated …?

 

No dice, said the Counsel’s office. The preparer should have known.

 

The items deducted constituted a substantial part of the return. 

TRANSLATION: It was a big deduction.

And therefore the preparer penalty is appropriate.  

TRANSLATION: Someone has to pay.

Mind you, a Chief Counsel memorandum is internal to the IRS. The taxpayer – and by extension, its CPA firm – might appeal the matter to the Tax Court. I would expect them to, frankly. The memorandum is just the IRS’ side.

For the home gamers, today we have been discussing Chief Counsel Memorandum 20223301F.

 

Owing Partnership Tax As A Partner

 

We have wrapped-up (almost) another filing season here at Galactic Command. I include “almost” as we have nonprofit 990s due next month, but for the most part the heavy lifting is done.

Tax seasons 2020 and 2021 have been a real peach.

I am looking at a tax case that mirrors a conversation I was having with one of our CPAs two or three days ago. He was preparing a return for someone with significant partnership investments. The two I looked at are commonly described as “trader” partnerships.

The tax reporting for trader partnerships can be confusing, especially for younger practitioners. A normal investment partnership buys and sells stocks and securities, collects interest and dividends and has capital gains or losses along the way. The tax reporting shows interest and dividends and capital gains and losses – in short, it makes sense.

The trader partnership adds one more thing: it actively buys and sells stocks and securities as a business activity, so to speak. Think of it as a day trader as opposed to a long-term investor. The tax issue is that one has interest, dividends and capital gains and losses from the trader side as well as the nontrader side. The trader partnership separates the two, with the result that trading dividends (as an example) might be reported somewhere different on the Schedule K-1 from nontrading dividends. If you don’t know the theory, it doesn’t make sense.

The two partnerships pumped out meaningful taxable income.

What they did not do was pump out equivalent cash distributions. In fact, I would say that the partnerships distributed approximately enough cash to pay the taxes thereon, assuming that the partner was near the highest tax bracket.

The client had issues with the draft tax return.

Why?

There was no way he could have that much income as he did not receive that much cash.

And therein is a lesson in partnership taxation.

Let’s take a look at the Dodd case.

Dodd was the office manager at a D.C. law firm. The firm specialized in real estate and construction law.

She in turn became a 33.5% member in a partnership (Cadillac) transacting in – wait on it – the purchase, leasing and sale of real property. The other 66.5% partner was an attorney-partner in the law firm.

Routine so far.

Cadillac did well in 2013. Her share of gains from property sales was over a $1 million. Her cash distributions were approximately $200 grand.

Got it: 20 cents on the dollar.

When she prepared her individual return, she included that $1 million-plus gain as well as partnership losses. She owed around $170 grand with the return.

She did not send a check for the amount due.

The case has been bogged-down in tax procedure for several years. The IRS wanted its tax, and Dodd in turn requested Collections (CDP) hearings. We have had three rounds of back-and-forth, with the result that we are still talking about the case in 2021.

Her argument?

Simple. She had never received the $1 million. The money instead went to the bank to pay down a line of credit.

This is going to turn out badly for Dodd.

At 30 thousand feet, partnership taxation is relatively intuitive. A partnership does not pay taxes itself. Rather it files a tax return, and the partners in the partnership are allocated their share of the income and are themselves responsible for paying taxes on that share.

The complexity in partnership taxation comes primarily from how one allocates the income, as tax attorneys and CPAs have had decades to bend the rules.

Notice that I did not say anything about cash distributions.

Mind you, it is bad business to pump-out taxable income without distributing cash to cover the tax, but it is unlikely that a partnership will distribute cash exactly equal to its income. Why? Here are a couple of reasons that come immediately to mind:

·      Depreciation

The partnership buys something and depreciates it. It is likely that the depreciation (which follows tax rules) will not equal the cash payments for whatever was bought.

·      Debt

Any cash used to repay the bank is cash not available to distribute to the partners.

There is, by the way, a technique to discourage creditors of a partner from taking a partner’s partnership interest. Why would a creditor do this? To get to those distributions, of course.

There is a legal issue here, however. Let’s say that you, me and Lucy decided to form a partnership. Lucy has financial difficulties, and one of her creditors takes over her partnership interest. You and I did not form a partnership with Lucy’s creditor; we formed a partnership with Lucy. That creditor cannot just come in and force you and me to be partners with him/her. The best the creditor can do is get a “charging order,” which means the creditor receives only the right to Lucy’s distributions. The creditor cannot otherwise vote, demand the sale of assets or force the termination of the partnership.

What do you and I do in response to the new guy?

The creditor will have to report Lucy’s share of the partnership income, of course.

We in turn make no distributions to Lucy - or to the new guy. The partnership distributes to you and me, but that creditor is on his/her own. Sorry. Not. Go away.

As you can guess, creditors are not big fans of going after debtor partnership interests.

Back to Dodd.

What did the Court say?

No matter the reason for nondistribution, each partner must pay taxes on his distributive share.”

To restate:

Each partner is taxed on the its distributive share of partnership income without regard to whether the income is actually distributed.”

Dodd had no hope with this argument.

Maybe she would have better luck with her Collections appeal, but that is not the topic of our discussion this time.

We have been discussing Dodd v Commissioner, T.C. Memo 2021-118.

Receiving An IRS Lock-In Letter

 

A client recently picked up his personal tax return. He asked to see me.

There was tax due with the return. I thought he had adjusted his withholding to increase his take-home pay, as he had spoken to me of financial stress. I am not a fan of doing this, as tax is due whether one withholds or not.   

He could not have tax due with his return, he explained, as he had received a lock-in letter from the IRS.

There is something I do not often see.

There are two versions of the lock-in letter: one sent to the employee and another to the employer. The IRS is telling both that it wants additional withholding from each paycheck, commonly meaning single withholding with no dependents.

The lock-in surprised me, as my client is not one to game the system. What he did was fall behind on his taxes due to a failed business. There are liens – IRS and private - that he is working through.

The IRS sends the employee a letter informing him/her that his/her withholdings are too low. The IRS wants the employee to self-adjust by increasing their withholding.

If that fails, the IRS sends the employer a letter. An employer has 60 days from the date of the letter to unilaterally adjust the employee’s withholdings.

The employee can quit, but the lock is good for 12 months. The employee will have to go somewhere else for a year before returning if he/she wishes to avoid the lock.

The 60 days has two purposes:

(1)  To allow the employer time to make the changes, and 

(2)  To prompt the employee to contact the IRS. If so – and if the employee can persuade the IRS – the IRS may modify the lock.

If the employee keeps his/her nose clean, he/she can request the IRS remove the lock-in. Figure that it will take about three years of tax returns, however, so it is best to avoid the lock altogether.

The employer is extremely unlikely to buck the IRS, as the employer might then draw surrogate liability. One might be a valued employee, but one is not that valued. 

Let’s look at a case.

Charles G worked for Volvo Trucks North America (VTNA). He submitted a W-4 to VTNA claiming that he was exempt from income tax withholding. He also requested VTNA to stop withholding social security taxes.

VTNA was surprisingly tolerant. It spotted Charles a 99-dependent W-4 (affecting income tax withholding), although it could not do anything about the social security.

Charles went a couple of years or so before the IRS contacted him. He blew it off, so the IRS sent VTNA a lock-in letter.

Charles went ballistic.

Charles accused the IRS and VTNA of “acting in violation of the Racketeer Influenced and Corrupt Organizations Act (RICO).”

Wow. I wonder how it went come employee review time.

The Court of course dismissed Charles’ claim against VTNA. In general, an employer must follow an employee’s request concerning withholding. If the employee asserts that he/she is exempt from withholding, then the employer must comply with such request unless certain situations occur. A lock-in letter is one of those situations.

It sounds rather self-evident, truthfully.

It also sounds like Charles was a bit of a tax protestor. A word of advice: don’t go there with Charles. Your chances of success are between zero and none, and the list of dead bodies on that hill stretches interminably. Several years ago, we represented a business having an officer the IRS considered a protestor. I did not agree with the IRS on this, but I admit that he was getting close to the line.  The audit was … unpleasant. There was no question that school was in session, and the IRS was looking to teach a lesson.

Our case this time was Giles v Volvo Trucks of North America, 551 F. Supp 2^nd 359.

Becoming Personally Liable For An Estate’s Taxes

 

I had lunch with a friend recently. He is executor for an estate and was telling me about some … questionable third-party behavior and document discoveries. I left the conversation underwhelmed with his attorney and recommending a replacement as soon as possible. There are two other beneficiaries to this estate, and he has a fiduciary responsibility as executor.

Granted, all are family and get along. The risk - it seems to me - is minimal.

It is not always that way. I have a client whose family was ripped apart by an inheritance. I shake my head, as there was not enough money there (methinks) to spat over, much less exact lifelong grudges. However, he was executor and so-and-so received such-and-such back when Carter first started making liver pills and he should have offset someone for … oh, who knows.

Being executor can be a thankless job.

It can also get one into trouble.

Let’s take a look at the Lee estate.

Kwang Lee died testate in September, 2001.

         COMMENT: Testate means someone died with a will.

A municipal court judge was named executor.

The judge filed the estate return in May, 2003.

COMMENT: The return was late, but there was some complexity as both spouses died within six months. There was language in the will about a-spouse-is-considered-to-survive-if that created some confusion.

COMMENT: It doesn’t matter. You know the IRS is coming in with penalties.

The IRS audited the return.

 In April 2006 the IRS issued a Notice of Deficiency for over $1,000,000. 

COMMENT: The IRS also wanted a penalty over $255 grand for late filing.

The executor filed with the Tax Court.

 In February, 2007 the executor distributed $640,000 to the beneficiaries.

COMMENT: Pause on what happened here. The IRS wanted additional tax and penalties. The executor was contesting this in Tax Court. The issue was live when the executor distributed the money.

Is there a risk?

You bet.

What if the estate lost its case and did not have enough money left to pay the tax and penalties?

The Tax Court gave the executor a partial win: the estate owed closer to a half million dollars than a million. The Court also waived the penalties.

The estate did not have a half million dollars. It did have $182,941.

The estate submitted an offer in compromise to the IRS for $182,941.

The IRS looked at the offer and said: are you kidding me? What about that $640,000 you distributed before its time?

The IRS pointed out this bad boy:

31 U.S. Code § 3713.Priority of Government claims

(a)

(1) A claim of the United States Government shall be paid first when—

(A) a person indebted to the Government is insolvent and—

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;

(ii) property of the debtor, if absent, is attached; or

(iii) an act of bankruptcy is committed; or

(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

(2) This subsection does not apply to a case under title 11.

(b) A representative of a person or an estate (except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government. 

The effect of Section 3713 is to make the executor personally liable for a debt to the U.S. when: 

o  The estate was rendered insolvent by a distribution, and

o  The executor had knowledge or notice of the government’s claim at the time of the distribution.

The judge/executor did the only thing he could do: he challenged the charge that he had actual knowledge of a deficiency when he distributed the $640,000.

The executor was hosed. I am not sure what more of a wake-up-call the executor needed than an IRS Notice of Deficiency. For goodness’ sake, he filed a petition with the Tax Court in response.

Maybe he thought that he would win in Tax Court.

He did, by the way, but partially. The tax was cut in half, and the penalties were waived.

Notice that the estate would not have had enough money had it lost the case in full. The tax would have been over a million, with additional penalties of a quarter million. Under the best of circumstances, the estate would have had cash of approximately $822 thousand and unable to pay in full.

In that case I doubt Section 3713 would have applied. The estate would have conserved its cash upon receiving a Notice of Deficiency.

But the estate did not conserve its cash upon receiving a Notice of Deficiency.

The executor became personally liable.

Mind you, this may work out. Perhaps the beneficiaries return the cash; perhaps there is a claim under a performance bond.

Still, why would an executor – especially a skilled attorney and municipal judge – go there?

Our case this time was Estate of Lee v Commissioner, T.C. Memo 2021-92.

Abandoning A Partnership Interest

I suspect that most taxpayers know that there is a difference between long-term capital gains and ordinary income. Long-term capital gains receive a lower tax rate, incentivizing one to prefer long-terms gains, if at all possible.

Capital losses are not as useful. Capital losses offset capital gains, whether short-term or long-term. If one has net capital losses left over, then one can claim up to $3,000 of such losses to offset non-capital gain income (think your W-2).

That $3,000 number has not changed since I was in school.

And there is an example of a back-door tax increase. Congress has imposed an effective tax increase by not pegging the $3,000 to (at least) the rate of inflation for the last how-many decades. It is the same thing they have done with the threshold amount for the net investment income or the additional Medicare tax. It is an easy way to raise taxes without publicly raising taxes.

I am looking at a case where two brothers owned Edwin Watts Golf. Most of the stores were located on real estate also owned by the brothers, so the brothers owned two things: a golf supply business and the real estate it was housed in.

In 2003 a private equity firm (Wellspring) offered the brothers $93 million for the business. The brothers took the money (so would I), kept the real estate and agreed to certain terms, such as Wellspring having control over any sale of the business. The brothers also received a small partnership position with Wellspring.

Why did they keep the real estate? Because the golf businesses were paying rent, meaning that even more money went their way.

The day eventually came when Wellspring wanted out; that is what private equity does, after all. It was looking at two offers: one was with Dick’s Sporting Goods and the other with Sun Capital.  Dick’s Sporting already had its own stores and would have no need for the existing golf shop locations. The brothers realized that would be catastrophic for the easy-peasy rental income that was coming in, so they threw their weight behind the offer by Sun Capital.

Now, one does not own a private equity firm by being a dummy, so Wellspring wanted something in return for choosing Sun Capital over Dick’s Sporting.

Fine, said the brothers: you can keep our share of the sales proceeds.

The brothers did not run the proposed transaction past their tax advisor. This was unfortunate, as there was a tax trap waiting to spring.  

Generally speaking, the sale or exchange of a partnership interest results in capital gain or loss. The partners received no cash from the sale. Assuming they had basis (that is, money invested) in the partnership, the sale or exchange would have resulted in a capital loss.

Granted, one can use capital losses against capital gains, but that means one needs capital gains.   What if you do not have enough gains? Any gains? We then get back to an obsolete $3,000 per year allowance. Have a big enough loss and one would need the lifespan of a Tolkien elf to use-up the loss.

The brothers’ accountant found out what happened during tax season and well after the fact. He too knew the issue with capital losses. He played a card, in truth the only card he had. Could what happened be reinterpreted as the abandonment of a partnership interest?

There is something you don’t see every day.

Let’s talk about it.

This talk gets us into Code sections, as the reasoning is that one does not have a “sale or exchange” of a partnership interest if one abandons the interest. This gets the tax nerd away from the capital gain/loss requirement of Section 741 and into the more temperate climes of Section 165. One would plan the transaction to get to a more favorable Code section (165) and avoid a less favorable one (741). 

There are hurdles here, though. The first two are generally not a problem, but the third can be brutal.

The first two are as follows:

(1) The taxpayer must show an intent to abandon the interest; and

(2)  The taxpayer must show an affirmative act of abandonment.

This is not particularly hard to do, methinks. I would send a letter to the tax matters or general partner indicating my intent to abandon the interest, and then I would send (to all partners, if possible) a letter that I have in fact abandoned my interest and relinquished all rights and benefits thereunder. This assumes there is no partners’ meeting. If there was a meeting, I would do it there. Heck, I might do both to avoid all doubt.

What is the third hurdle?

There can be no “consideration” on the way out.

Consideration in tax means more than just receiving money. It also includes someone assuming debt you were previously responsible for.

The rule-of-thumb in a general partnership is that the partners are responsible for their allocable share of partnership debt. This is a problem, especially if one is not interested in being liable for any share of any debt. This is how we got to limited partnerships, where the general partner is responsible for the debts and the limited partners are not.

Extrapolating the above, a general partner in a general partnership is going to have issues abandoning a partnership interest if the partnership has debt. The partnership would have to pay-off that debt, refinance the debt from recourse to nonrecourse, or perhaps a partner or group of partners could assume the debt, excluding the partner who wants to abandon.

Yea, the planning can be messy for a general partnership.

It would be less messy for a limited partner in a limited partnership.

Then we have the limited liability companies. (LLCs). Those bad boys have a splash of general partnership, a sprinkling of limited partnership, and they can result in a stew of both rules.

The third plank to the abandonment of a partnership interest can be formidable, depending on how the entity is organized and how the debts are structured. If a partner wants an abandonment, it is more likely than not that pieces on the board have to be moved in order to get there.   

The brothers’ accountant however had no chance to move pieces before Wellspring sold Edwin Watts Golf. He held his breath and prepared tax returns showing the brothers as abandoning their partnership interests. This gave them ordinary losses, meaning that the losses were immediately useful on their tax returns.

The IRS caught it and said “no way.”

There were multiple chapters in the telling of this story, but in the end the Court decided for the IRS.

Why?

Because the brothers had the option of structuring the transaction to obtain the tax result they desired. If they wanted an abandonment, then they should have taken the steps necessary for an abandonment. They did not. There is a long-standing doctrine in the Code that a taxpayer is allowed to structure a transaction anyway he/she wishes, but once structured the taxpayer has to live with the consequences. This doctrine is not tolerant of taxpayer do-overs.

The brothers had a capital and not an ordinary loss. They were limited to capital gains plus $3 grand per year. Yay.

Our case this time for the home gamers was Watts, T.C. Memo 2017-114.